Heating oil markets are tight as winter approaches

In petroleum markets, October is typically the time when attention shifts from transportation fuels to heating fuels. Strong global distillate demand and refinery outages have supported prompt distillate prices relative to those in the future. In its October 2012 Short-Term Energy and Winter Fuels Outlook the U.S. Energy Information Administration (EIA) is projecting that retail heating oil prices will average $3.80 per gallon this winter (October-March), which would be $0.07 per gallon above last winter's average of $3.73 per gallon, and the highest on record. Historically, heading into winter, heating oil prices for future delivery are higher than those for current delivery, encouraging inventory builds. However, this year, prices for future delivery are below current prices, so there is little if any incentive to buy product now and store it for sale later in the winter.

As the northern hemisphere prepares for winter, the demand for distillate fuels is typically strong as consumers fill tanks in preparation for the heating season. This year, as has been the case for the last several years, the seasonal increase in demand is occurring against a backdrop of tight global distillate markets in which supply and demand centers are geographically mismatched. Europe and Latin America produce less distillate fuels than they consume and have been relying on supply from the United States, mostly exports from the U.S. Gulf Coast. This trade has been mutually beneficial because it has provided U.S. refiners with an attractive market that has encouraged high refinery utilization, which also has supported the production of additional gasoline.

The tightness in global distillate markets is reflected in both the futures market prices and inventory levels in the United States. While U.S. distillate production is high, the global supply-demand balance for distillate fuels has created a price structure that has not encouraged inventory builds. In recent weeks, prompt prices for distillate fuel have risen compared to prices for fuel delivered in future months. For the week ending October 5, distillate inventories in the U.S. Northeast (PADDs 1A and 1B) were 28.3 million barrels, about 21.5 million barrels (43 percent) below their five-year average level (Figure 1). Distillate inventories have historically been used to meet normal winter heating demand but are also an important source of supply when demand surges as a result of unexpected or extreme cold spells. The low distillate inventories could contribute to heating oil price volatility this winter. In addition, outages at several major refineries, notably Petroleos de Venezuela's Amuay Refinery, Shell Oil's Pernis Refinery in the Netherlands, and Irving Oil's Saint John Refinery in Canada, have added to the fundamental market pressures in the Atlantic Basin.

Market tightness could be exacerbated by a regulatory change in New York state, which starting this heating season limits the sulfur content of home heating oil to 15 parts per million (ppm), matching the sulfur content limit for ultra-low sulfur diesel fuel (ULSD). This change results in an estimated additional 70,000 barrels per day (bbl/d) of ULSD demand on an annual basis, but in times of peak demand - such as during sustained cold temperatures - could be as high as 170,000 bbl/d (See EIA Northeast Refinery Study). The specification change also eliminates an equivalent amount of demand for high-sulfur heating oil, which is the specification currently used in other northeastern states. This demand shift could be significant because ULSD is less available globally than is high-sulfur distillate fuel and the major production center for ULSD is on the U.S. Gulf Coast.

Some factors could work to bring supplies to the Northeast as winter approaches. One is the late-September restart of Delta Air Lines' (Monroe Energy LLC) 185,000-bbl/d Trainer Refinery near Philadelphia, which had been idle for the past year. Some additional production could become available if other Northeast refineries increase runs in response to the current strong distillate margins. Additionally, the U.S. East Coast exported an average of 135,000 bbl/d of distillate fuel in 2012 through July. However, prices in the Northeast have recently risen compared with European markets. Heating oil in New York Harbor typically sells at a discount to similar fuel in northwest Europe, which prompts flows of distillate from the East Coast to Europe. But in recent weeks, that spread has flipped and New York Harbor distillate is selling at a small premium to European distillate. This change in price spreads could help keep some distillate in the domestic market. More supplies could also result from Colonial Pipeline's completion of a recent 55,000-bbl/d capacity expansion of a dedicated distillate pipeline from Houston, Texas, to Greensboro, North Carolina. Colonial is also expanding capacity by an additional 60,000-bbl/d from Greensboro to Linden, New Jersey, and that capacity could come online as early as the first quarter of 2013.

Besides factors unique to the distillate market, crude oil prices are a major determinant of heating oil prices. Brent spot prices are expected to average about $108 per barrel this winter, about 6 percent lower than last winter.

Weather will be the major factor affecting demand, and, thus, could also cause prices to vary significantly from the EIA forecast. Although the residential market share for heating oil has been declining as more consumers favor other primary heating fuels, consumption can still vary greatly based on weather. This year, winter temperatures are expected to return closer to normal levels after last year's very mild weather. Based on the National Oceanic and Atmospheric Administration (NOAA) weather forecast, EIA projects population-weighted U.S. heating degree days will be about 18 percent higher than last winter, which was the fourth warmest winter on record and the warmest since 1999-2000, but about 2 percent lower than the 30-year (1971-2000) average. Heating degree day projections vary between different regions. For example, heating degree days in the Northeast, which includes about 80 percent of all households that use heating oil as their primary heating fuel, are projected to be about 20 percent higher than last winter. However, any variation in actual weather from the forecast could cause demand to vary.